Computing cash flows

COMPUTING CASH FLOWS

Cash flows are either receipts (ie cash inflows and so are represented as a positive number in a statement of cash flows) or  payments (ie cash out flows and so are represented as a negative number using brackets in a statement of cash flows).

Cash flows are usually calculated as a missing figure. For example, when the opening balance of an asset, liability or equity item is reconciled to its closing balance using information from the statement of profit or loss and/or additional notes, the balancing figure is usually the cash flow.

Common cash flow calculations include the tax paid, which is an operating activity cash out flow, the payment to buy property plant and equipment (PPE) which is an investing activity cash out flow and dividends paid, which is a financing activity cash out flow. The following examples illustrate all three of these examples.

EXERCISE CALCULATING THE TAX PAID

At the start of the accounting period the company has a tax liability of $50 and at the reporting date a tax liability of $90. During the year the tax charged in the statement of profit or loss was $100.

Required: Calculate the tax paid.

Solution

It is necessary to reconcile the opening tax liability to the closing tax liability to reveal the cash flow – the tax paid - as the balancing figure. A vertical presentation of the numbers lends itself to noting the source of the numbers.

Tax liability

$

Explanation

Opening balance

50

Credit balance

Tax charge

100

The tax charged in the profit or loss means that the entity now owes more tax. The debit charged as the expense in profit or loss is posted and a credit to the tax liability account reflects the effect of increase in the tax liability

 

_____

 

Sub-total

150

This sub-total represents the amount of the tax liability that there would have been at the reporting date in the event that no tax had been paid

Cash flow – the payment of tax

60

This is the last figure written in the reconciliation. It is the balancing figure and explains why the actual year-end tax liability is smaller than the sub-total

 

_____

 

Closing balance

90

This is the closing balance of the tax liability

 

_____  

This simple technique of taking the opening balance of an item (in this case the tax liability) and adding (or subtracting) the non-cash transactions that have caused it to change, to then reveal the actual cash flow as the balancing figure, has wide application.

EXERCISE CALCULATING THE PAYMENTS TO BUY PPE

At the start of the accounting period the company has PPE with a carrying amount of $100. At the reporting date the carrying amount of the PPE is $300. During the year depreciation charged was $20, a revaluation surplus of $60 was recorded and PPE with a carrying amount of $15 was sold.

Required: Calculate the cash paid to buy new PPE.

Solution

Here we can take the opening balance of PPE and reconcile it to the closing balance by adjusting it for the changes that have arisen in period that are not cash flows. The balancing figure is the cash spent to buy new PPE.

PPE

$

Explanation

Opening balance

100

Debit balance

Deprecation

(20)

Deprecation reduces the carrying amount of the PPE without being a cash flow. The double entry for depreciation is a debit to statement of profit or loss to reflect the expense and to credit the asset to reflect its consumption.

Revaluation surplus

60

The revaluation gain increases PPE without being a cash flow. The double entry is a credit to the revaluation surplus to reflect the gain and to debit the asset to reflect its increase

Disposal

(15)

The carrying amount of the PPE that has been disposed of reduces the PPE thus a credit to the asset account which is then posted as a debit in the disposals account

 

_____

 

Sub-total

125

This sub-total represents the balance of the PPE if no PPE had been bought for cash

Cash flow – the payment to buy PPE

175

This is the last figure written in the reconciliation This balancing figure explains why the actual PPE at the reporting date is greater than the sub-total

 

_____

 

Closing balance

300

 

 

_____

 

EXERCISE CALCULATING THE DIVIDEND PAID

At the start of the accounting period the company has retained earnings of $500 and at the reporting date retained earnings are $700. During the reporting period a profit for the year of $450 was reported.

Required: Calculate the dividend paid.

Solution

As before, to ascertain the cash flow – in this case dividends paid - we can reconcile an opening to closing balance – in this case retained earnings. This working is in effect an extract from the statement of changes in equity.

Retained earnings

$

Explanation

Opening balance

500

Credit balance

Profit for the year

450

The profit for the year is a credit and increases the retained earnings

 

_____

 

 

950

This sub-total represents the balance on retained earnings in the event that no dividends have been paid

Cash flow – the dividends paid

250

This is the last figure written in the reconciliation. This balancing figure of dividends paid explains why the actual year-end retained earnings is less

 

_____

 

Closing balance

700

 

 

_____

 

CLASSIFICATION OF CASH FLOWS

IAS 7, Statement of Cash Flows requires an entity to present a statement of cash flows as an integral part of its primary financial statements. A statement of cash flow classifies and presents cash flows under three headings:

(i) Operating activities

(ii) Investing activities and

(iii) Financing activities

Operating activities can be presented in two different ways. The first is the direct method which shows the actual cash flows from operating activities – for example, the receipts from customers and the payments to suppliers and staff. The second is the indirect method which reconciles profit before tax to cash generated from operating profit. Under both of these methods the interest paid and taxation paid are presented as cash outflows.

Investing activity cash flows are those that relate to non-current assets. Examples of investing cash flows include the cash outflow on buying property plant and equipment, the sale proceeds on the disposal of non-current assets and any cash returns received arising from investments.

Financing activity cash flows relate to cash flows arising from the way the entity is financed. Entities are financed by a mixture of cash from borrowings from third parties (debt) and by the shareholders (equity). Examples of financing cash flows include the cash received from new borrowings or the cash repayment of debt as well as the cash flows with shareholders in the form of cash receipts following a new share issue or the cash paid to them in the form of dividends.

This topic is examined in much more depth in the F7 examination than it is at F3. For example, in F3, an extract, or the whole statement of cash flow might be required. F7, however, is more likely to ask for an extract from the statement of cash flows using more complex transactions (for example, the purchase of PPE using finance leases).  However, that does not mean that F7 will never require the preparation of a complete statement of cash flows so be prepared.

OPERATING ACTIVITIES – THE INDIRECT METHOD AND DIRECT METHOD

There are two different ways of starting the cash flow statement, as IAS 7, Statement of Cash Flows permits using either the 'direct' or 'indirect' method for operating activities.

The direct method is intuitive as it means the statement of cash flow starts with the source of operating cash flows. This is the cash receipts from customers. The operating cash out flows are payments for wages, to suppliers and for other operating expenses are then deducted. Finally the payments for interest and tax are deducted.

Alternatively, the indirect method starts with profit before tax rather than a cash receipt. The profit before tax is then reconciled to the cash that it has generated. This means that the figures at the start of the cash flow statement are not cash flows at all.  In that initial reconciliation, expenses that have been charged against profit that are not cash out flows; for example depreciation and losses, have to be added back, and non-cash income; for example investment income and profits are deducted. The changes in inventory, trade receivables and trade payables (working capital) do not impact on the measurement profit but these changes will have impacted on cash and so further adjustments are made. For example, an increase in the levels of inventory and receivables will have not impacted on profit but will have had an adverse impact on the cash flow of the business. Thus in the reconciliation process the increases in inventory and trade receivables are deducted. Conversely decreases in inventory and trade receivables are deducted. The opposite is applicable for trade payables. Finally the payments for interest and tax are presented.

The following exercise illustrates both the direct and indirect methods operating activities section.

EXERCISE: THE DIRECT AND INDIRECT METHOD

Extracts from the financial statements are as follows

  $  

Operating profit

80,000

 

Investment income

12,000

 

Finance costs

(10,000)

 

Profit before tax

82,000

 

Tax

(32,000)

 

Profit for the year

50,000

 

Other comprehensive income

 

 

Revaluation gain

40,000

 

Total comprehensive income

90,000

 

  Closing balance

$ Opening balance

$

Current assets

 

 

Inventory

30,000

25,000

Receivables

20,000

26,000

Current liabilities

 

 

Trade payables

14,000

11,000

Additional information

During the year depreciation of $50,000 and amortisation of $40,000 was charged to profit.  

Receipts from customers, combined with cash sales, were $800,000, payments to suppliers of raw materials $400,000, other operating cash payments were $100,000 and cash paid on behalf and to employees was $126,000.

Interest paid is $12,000 and taxation paid is $13,000.

Required:

(a) Using the direct method prepare the operating activities section of the statement of cash flows.

(b) Using the indirect method determine the operating activities section of the statement of cash flows.

Answer (a) direct method

The direct method is relatively straightforward in that all the data are cash flows so it is really just a case of listing the receipts as positive and the payments as negative.

Operating activities – 

Direct method

$

$

Cash received from customers

800,000

 

Cash paid to suppliers

(400,000)

 

Cash paid to staff

(100,000)

 

Other operating payments

(126,000)

 

Cash generated

174,000

 

Interest paid

(12,000)

 

Taxation paid

(13,000)

149,000

Answer (b) indirect method

The indirect method is more commonly examined. Here as we start with profit before tax we have to add back all the non-cash expenses charged, deduct the non-cash income and adjust for the changes in working capital. Only then are the two actual cash flows of interest paid and tax paid presented. Having a good understanding of the format of the statement of cash flows is key to a successful attempt at these questions.

Operating activities – Indirect method

$

$

Operating activities

 

 

Profit before tax

82,000

 

Investment income

(12,000)

 

Finance cost

10,000

 

Depreciation

50,000

 

Amortisation

40,000

 

Increase in inventory

(30,000 – 25,000)

(5,000)

 

Decrease in receivables 

(20,000 – 26,000)

6,000

 

Increase in payables

(14,000 – 11,000)

3,000

 

Cash generated

174,000

 

Interest paid

(12,000)

 

Taxation paid

(13,000)

 

149,000

Note how whichever method is used that the same cash is generated from operating activities.

FORMAT OF THE CASH FLOW STATEMENT – 

INDIRECT METHOD

You may be asked to prepare a statement of cash flows. The following is a pro forma showing the indirect method.

1. Operating activities

   

Profit before tax

X

 

Investment income

(X)

 

Finance cost

X

 

Depreciation

X

 

Less capital government grant released

(X)

 

Amortisation of intangible assets

X

 

Impairment loss charged in profit or loss

X

 

Loss on disposal of assets (profit)

X / (X)

 

Increase in provisions (decrease)

X / (X)

 

Changes in working capital

 

 

Increase / decrease in inventory

(X) / X

 

Increase / decrease in receivables and prepayments

(X) / X

 

Increase / decrease in trade payables and accruals

X / (X)

 

Cash generated

X

 

Interest paid

(X)

 

Taxation paid

(X)

X

 

2. Investing activities

 

 

Payments to buy PPE / Intangibles / Investments

(X)

 

Proceeds from sale of PPE / Intangibles / Investments

X

 

Dividends received from investments

X

 

Capital government grants received

X

(X)

 

3. Financing activities

 

 

Proceeds from an equity share issue

X

 

Dividends paid

(X)

 

Proceeds from the issue of new debt

X

 

Repayment of debt

(X)

 

Capital repayment of finance lease obligations

(X)

X/(X)

Change in cash and cash equivalents

 

X/(X)

Opening cash and cash equivalents

 

X/(X)

Closing cash and cash equivalents

 

X/(X)

Cash and cash equivalents comprise cash on hand and demand deposits, together with short-term, highly liquid investments that are readily convertible to a known amount of cash, and that are subject to an insignificant risk of changes in value.

Tom Clendon FCCA is a senior lecturer based in Singapore and he lectures for FTMS Global in their South East Asia colleges

part 2 : Measurement and depreciation

This is the second of two articles, and considers revaluation of property, plant and equipment (PPE) and its derecognition. The first part of the article (see 'Related links') considered the initial measurement and depreciation of PPE.
There are rather more differences between IAS 16, Property, Plant and Equipment (the international standard) and FRS 15, Tangible Fixed Assets (the UK standard) in relation to revaluation and derecognition compared to initial measurement and depreciation. For both topics addressed in this article, the international position is outlined first, and then compared to the UK position.

REVALUATION OF PPE – IAS 16 POSITION

General principles
IAS 16 allows entities the choice of two valuation models for PPE – the cost model or the revaluation model. Each model needs to be applied consistently to all PPE of the same ‘class’. A class of assets is a grouping of assets that have a similar nature or function within the business. For example, properties would typically be one class of assets, and plant and equipment another. Additionally, if the revaluation model is chosen, the revaluations need to be kept up to date, although IAS 16 is not specific as to how often assets need to be revalued.
When the revaluation model is used, assets are carried at their fair value, defined as ‘the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction’.
Revaluation gains
Revaluation gains are recognised in equity unless they reverse revaluation losses on the same asset that were previously recognised in the income statement. In these circumstances, the revaluation gain is recognised in the income statement. Revaluation changes the depreciable amount of an asset so subsequent depreciation charges are affected.
EXAMPLE 1
A property was purchased on 1 January 20X0 for $2m (estimated depreciable amount $1m – useful economic life 50 years). Annual depreciation of $20,000 was charged from 20X0 to 20X4 inclusive and on 1 January 20X5 the carrying value of the property was $1.9m. The property was revalued to $2.8m on 1 January 20X5 (estimated depreciable amount $1.35m – the estimated useful economic life was unchanged). Show the treatment of the revaluation surplus and compute the revised annual depreciation charge.
Solution
The revaluation surplus of $900,000 ($2.8m – $1.9m) is recognised in the statement of changes in equity by crediting a revaluation reserve. The depreciable amount of the property is now $1.35m and the remaining estimated useful economic life 45 years (50 years from 1 January 20X0). Therefore, the depreciation charge from 20X5 onwards would be $30,000 ($1.35m x 1/45).
A revaluation usually increases the annual depreciation charge in the income statement. In the above example, the annual increase is $10,000 ($30,000 – $20,000). IAS 16 allows (but does not require) entities to make a transfer of this ‘excess depreciation’ from the revaluation reserve directly to retained earnings.
Revaluation losses
Revaluation losses are recognised in the income statement. The only exception to this rule is where a revaluation surplus exists relating to a previous revaluation of that asset. To that extent, a revaluation loss can be recognised in equity.
EXAMPLE 2
The property referred to in Example 1 was revalued on 31 December 20X6. Its fair value had fallen to $1.5m. Compute the revaluation loss and state how it should be treated in the financial statements.
Solution
The carrying value of the property at 31 December 20X6 would have been $2.74m ($2.8m – 2 x $30,000). This means that the revaluation deficit is $1.24m ($2.74m – $1.5m).
If the transfer of excess depreciation (see above) is not made, then the balance in the revaluation reserve relating to this asset is $900,000 (see Example 1). Therefore $900,000 is deducted from equity and $340,000 ($1.24m – $900,000) is charged to the income statement.
If the transfer of excess depreciation is made, then the balance on the revaluation reserve at 31 December 20X6 is $880,000 ($900,000 – 2 x $10,000). Therefore $880,000 is deducted from equity and $360,000 ($1.24m – $880,000) charged to the income statement.

REVALUATION OF PPE – FRS 15 POSITION

Although the basic position in FRS 15 is similar to that of IAS 16, there are differences:

• FRS 15 is more specific than IAS 16 regarding the frequency of valuations. FRS 15 states that, as a minimum, assets should be revalued every five years.
• Under FRS 15 the amount to which a fixed asset is revalued is different than under IAS 16. As far as properties are concerned (these probably being the class of fixed asset most likely to be carried at valuation) the basic valuation principle is value for existing use – not reflecting any development potential. Notional, directly attributable acquisition costs should also be included where material. However, specialised properties may need to be valued on the basis of depreciated replacement cost, since there may be no data on which to base an ‘existing use’ valuation. If properties are surplus to the entity’s requirements, then they should be valued at open market value net of expected directly attributable selling costs. 
• Revaluation losses that are caused by a clear consumption of economic benefits, for example physical damage to an asset, should be recognised in the profit and loss account. Such losses are recognised as an operating cost similar to depreciation. 
• Other revaluation losses, for example the effect of a general fall in market values on a portfolio of properties, should be partly recognised in the statement of total recognised gains and losses. However, if the loss is such that the carrying amount of the asset falls below depreciated historical cost, then any further losses need to be recognised in the profit and loss account. 

EXAMPLE 3
State how the answers to Examples 1 and 2 would change if FRS 15 were applied rather than IAS 16.
Solution
The answer to Example 1 would not change at all. For Example 2, if the revaluation loss was caused by a consumption of economic benefits, then the whole loss would be recognised in the profit and loss account. If the revaluation loss was caused by general factors, then it would be necessary to compute the depreciated historical cost of the property. This is the carrying value of the property at 31 December 20X6 if the first revaluation on 1 January 20X5 had not been carried out and would be $1.86m ($2m – 7 x $20,000). The actual carrying value of the property at 31 December 20X6 was $2.74m (see Example 2). Therefore, of the revaluation loss of $1.24m (see Example 2), $880,000 ($2.74m – $1.86m) is charged to the statement of total recognised gains and losses, and the balance of $360,000 ($1.24m – $880,000) charged to the profit and loss account.

DERECOGNITION OF PPE – THE IAS 16 POSITION

PPE should be derecognised (removed from PPE) either on disposal or when no future economic benefits are expected from the asset (in other words, it is effectively scrapped). A gain or loss on disposal is recognised as the difference between the disposal proceeds and the carrying value of the asset (using the cost or revaluation model) at the date of disposal. This net gain is included in the income statement – the sales proceeds should not be recognised as revenue.
Where assets are measured using the revaluation model, any remaining balance in the revaluation reserve relating to the asset disposed of is transferred directly to retained earnings. No recycling of this balance into the income statement is permitted.

DISPOSAL OF ASSETS – IFRS 5 POSITION

IFRS 5, Non-current assets held for sale and discontinued operations is another standard that deals with the disposal of non-current assets and discontinued operations. An item of PPE becomes subject to the provisions of IFRS 5 (rather than IAS 16) if it is classified as held for sale. This classification can either be made for a single asset (where the planned disposal of an individual and fairly substantial asset takes place) or for a group of assets (where the disposal of a business component takes place). This article considers the implications of disposing of a single asset.
IFRS 5 is only applied if the held for sale criteria are satisfied, and an asset is classified as held for sale if its carrying amount will be recovered principally through a sale transaction rather than through continued use. For this to be the case, the asset must be available for immediate sale in its present condition and its sale must be highly probable. Therefore, an appropriate level of management must be committed to a plan to sell the asset, and an active programme to locate a buyer and complete the plan must have been initiated. The asset needs to be actively marketed at a reasonable price, and a successful sale should normally be expected within one year of the date of classification.
The types of asset that would typically satisfy the above criteria would be property, and very substantial items of plant and equipment. The normal disposal or scrapping of plant and equipment towards the end of its useful life would be subject to the provisions of IAS 16. When an asset is classified as held for sale, IFRS 5 requires that it be moved from its existing balance sheet presentation (non-current assets) to a new category of the balance sheet – ‘non-current assets held for sale’. No further depreciation is charged as its carrying value will be recovered principally through sale rather than continuing use.
The existing carrying value of the asset is compared with its ‘fair value less costs to sell’ (effectively the selling price less selling costs). If fair value less costs to sell is below the current carrying value, then the asset is written down to fair value less costs to sell and an impairment loss recognised. When the asset is sold, any difference between the new carrying value and the net selling price is shown as a profit or loss on sale.
EXAMPLE 4
An asset has a carrying value of $600,000. It is classified as held for sale on 30 September 20X6. At that date its fair value less costs to sell is estimated at $550,000. The asset was sold for $555,000 on 30 November 20X6. The year end of the entity is 31 December 20X6.

1. How would the classification as held for sale, and subsequent disposal, be treated in the 20X6 financial statements?
2. How would the answer differ if the carrying value of the asset at 30 September 20X6 was $500,000, with all other figures remaining the same?

Solution 1

1. On 30 September 20X6, the asset would be written down to its fair value less costs to sell of $550,000 and an impairment loss of $50,000 recognised. It would be removed from non-current assets and presented in ‘non-current assets held for sale’. On 30 November 20X6 a profit on sale of $5,000 would be recognised.
2. On 30 September 20X6 the asset would be transferred to non-current assets held for sale at its existing carrying value of $500,000. When the asset is sold on 30 November 20X6, a profit on sale of $55,000 would be recognised.

Where an asset is measured under the revaluation model then IFRS 5 requires that its revaluation must be updated immediately prior to being classified as held for sale. The effect of this treatment is that the selling costs will always be charged to the income statement at the date the asset is classified as held for sale.
EXAMPLE 5
An asset being classified as held for sale is currently carried under the revaluation model at $600,000. Its latest fair value is $700,000 and the estimated costs of selling the asset are $10,000. Show how this transaction would be recorded in the financial statements.
Solution
Immediately prior to being classified as held for sale, the asset would be revalued to its latest fair value of $700,000, with a credit of $100,000 to equity. The fair value less costs to sell of the asset is $690,000 ($700,000 – $10,000). On reclassification, the asset would be written down to this value (being lower than the updated revalued amount) and $10,000 charged to the income statement.

DERECOGNITION OF PPE – FRS 15 POSITION

The FRS 15 position is effectively identical to that of IAS 16 in as far as derecognition of PPE is covered by IAS 16. However, there is no UK standard equivalent to IFRS 5, although the UK Accounting Standards Board has issued an exposure draft that is very similar to IFRS 5.
Paul Robins is a lecturer at Kaplan

Part 1 : Measurement and depreciation

This is the first of two articles which consider the main features of IAS 16, Property, Plant and Equipment (PPE). Both articles are relevant to students studying the International or UK stream. The series will primarily focus on the requirements of IAS 16, but will also compare IAS 16 with the equivalent UK standard, FRS 15, Tangible Fixed Assets. These standards deal with the four main aspects of financial reporting of PPE that are likely to be of major relevance in the exams, namely:

• initial measurement and depreciation – covered in this article
• revaluation and derecognition – covered in the second article.
  

Note: There are no significant differences between IAS 16 and FRS 15 as far as either initial measurement or depreciation of PPE are concerned.

IAS 16 defines PPE as tangible items that are:

• held for use in the production or supply of goods or services, for rental to others, or for administrative purposes and
• expected to be used during more than one accounting period.
  
  

THE INITIAL MEASUREMENT OF PPE

IAS 16 requires that PPE should initially be measured at ‘cost’. The cost of an item of PPE comprises:

• the cost of purchase, net of any trade discounts plus any import duties and non-refundable sales taxes
• any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management.
  

These are costs that would have been avoided if the asset had not been purchased or constructed. General overhead costs cannot be allocated to the cost of PPE. Directly attributable costs include:

• employee benefits payable to staff installing, constructing, or initially testing the asset
• site preparation
• professional fees directly associated with the installation, construction, or initial testing of the asset
• any other overhead costs directly associated with the installation, construction, or initial testing of the asset.
  

Where these costs are incurred over a period of time (such as employee benefits), the period for which the costs can be included in the cost of PPE ends when the asset is ready for use, even if the asset is not brought into use until a later date. As soon as an asset is capable of operating it is ready for use. The fact that it may not operate at normal levels immediately, because demand has not yet built up, does not justify further capitalisation of costs in this period. Any abnormal costs (for example, wasted material) cannot be included in the cost of PPE.

IAS 16 does not specifically address the issue of whether borrowing costs associated with the financing of a constructed asset can be regarded as a directly attributable cost of construction. This issue is addressed in IAS 23, Borrowing Costs. IAS 23 requires the inclusion of borrowing costs as part of the cost of constructing the asset. In order to be consistent with the treatment of ‘other costs’, only those finance costs that would have been avoided if the asset had not been constructed are eligible for inclusion. If the entity has borrowed funds specifically to finance the construction of an asset, then the amount to be capitalised is the actual finance costs incurred. Where the borrowings form part of the general borrowing of the entity, then a capitalisation rate that represents the weighted average borrowing rate of the entity should be used.

The cost of the asset will include the best available estimate of the costs of dismantling and removing the item and restoring the site on which it is located, where the entity has incurred an obligation to incur such costs by the date on which the cost is initially established. This is a component of cost to the extent that it is recognised as a provision under IAS 37, Provisions, Contingent Liabilities and Contingent Assets. In accordance with the principles of IAS 37, the amount to be capitalised in such circumstances would be the amount of foreseeable expenditure appropriately discounted where the effect is material.

EXAMPLE 1
On 1 October 20X6, Omega began the construction of a new factory. Costs relating to the factory, incurred in the year ended 30 September 20X7, are as follows:

	$000
Purchase of the land	10,000
Costs of dismantling existing structures on the site	500
Purchase of materials to construct the factory	6,000
Employment costs (Note 1)	1,800
Production overheads directly related to the construction (Note 2)	1,200
Allocated general administrative overheads	600
Architects’ and consultants’ fees directly related to the construction	400
Costs of relocating staff who are to work at the new factory	300
Costs relating to the formal opening of the factory	200
Interest on loan to partly finance the construction of the factory (Note 3)	1,200

Note 1
The factory was constructed in the eight months ended 31 May 20X7. It was brought into use on 30 June 20X7. The employment costs are for the nine months to 30 June 20X7.

Note 2
The production overheads were incurred in the eight months ended 31 May 20X7. They included an abnormal cost of $200,000, caused by the need to rectify damage resulting from a gas leak.

Note 3
Omega received the loan of $12m on 1 October 20X6. The loan carries a rate of interest of 10% per annum.

Note 4
The factory has an expected useful economic life of 20 years. At that time the factory will be demolished and the site returned to its original condition. This is a legal obligation that arose on signing the contract to purchase the land. The expected costs of fulfilling this obligation are $2m. An appropriate annual discount rate is 8%.

Requirement
Compute the initial carrying value of the factory (see solution).

DEPRECIATION OF PPE

IAS 16 defines depreciation as ‘the systematic allocation of the depreciable amount of an asset over its useful life’. ‘Depreciable amount’ is the cost of an asset, cost less residual value, or other amount (for more on the revaluation of the asset, see the second article in the August 2007 issue of student accountant). Depreciation is not providing for loss of value of an asset, but is an accrual technique that allocates the depreciable amount to the periods expected to benefit from the asset. Therefore assets that are increasing in value still need to be depreciated.

IAS 16 requires that depreciation should be recognised as an expense in the income statement, unless it is permitted to be included in the carrying amount of another asset. An example of this practice would be the possible inclusion of depreciation in the costs incurred on a construction contract that are carried forward and matched against future income from the contract, under the provisions of IAS 11.

A number of methods can be used to allocate depreciation to specific accounting periods. Two of the more common methods, specifically mentioned in IAS 16, are the straight line method, and the reducing (or diminishing) balance method.

The assessments of the useful life (UL) and residual value (RV) of an asset are extremely subjective. They will only be known for certain after the asset is sold or scrapped, and this is too late for the purpose of computing annual depreciation. Therefore, IAS 16 requires that the estimates should be reviewed at the end of each reporting period. If either changes significantly, then that change should be accounted for over the remaining estimated useful economic life.

EXAMPLE 2
An item of plant was acquired for $220,000 on 1 January 20X6. The estimated UL of the plant was five years and the estimated RV was $20,000. The asset is depreciated on a straight line basis. On 31 December 20X6 the future estimate of the UL of the plant was changed to three years, with an estimated RV of $12,000.

At the date of purchase, the plant’s depreciable amount would have been $200,000 ($220,000 – $20,000). Therefore, depreciation of $40,000 would have been charged in 20X6, and the carrying value would have been $180,000 at the end of 20X6. Given the reassessment of the UL and RV, the depreciable amount at the end of 20X6 is $168,000 ($180,000 – $12,000) over three years. Therefore, the depreciation charges in 20X7, 20X8 and 20X9 will be $56,000 ($168,000/3) unless there are future changes in estimates. Where an asset comprises two or more major components with substantially different economic lives, each component should be accounted for separately for depreciation purposes, and each depreciated over its UL.

EXAMPLE 3
On 1 January 20X2, an entity purchased a furnace for $200,000. The estimated UL of the furnace was 10 years, but its lining needed replacing after five years. On 1 January 20X2 the entity estimated that the cost of relining the furnace (at 1 January 20X2 prices) was $50,000. The lining was replaced on 1 January 20X7 at a cost of $70,000.

Requirement
Compute the annual depreciation charges on the furnace for each year of its life.

Solution

20X2–20X6 inclusive
The asset has two depreciable components: the lining element (allocated cost $50,000 – UL five years); and the balance of the cost (allocated cost $150,000 – UL 10 years). Therefore, the annual depreciation is $25,000 ($50,000 x 1/5 + $150,000 x 1/10). At 31 December 20X6, the ‘lining component’ has a written down value of zero.

20X7–20Y1 inclusive
The $70,000 spent on the new lining is treated as the replacement of a separate component of an asset and added to PPE. The annual depreciation is now $29,000 ($70,000 x 1/5 + $150,000 x 1/10).

Paul Robins is a lecturer at Kaplan

How to account for property

Relevant to Papers F7 and P2
With very few exceptions, all land in Hong Kong is owned by the Government and leased out for a limited period. It does not matter if the properties are high-rise buildings, residential, offices or factories, they are built on land under a government lease.

Developers of these properties lease lots of land from the Government and develop the land according to the lease conditions, such as to construct buildings on the land according to the specifications within a specified period.

Individual units of these lots of land and buildings are usually sold as undivided shares in the lots. Interests of all parties, including future buyers of the units, are governed by the deeds of mutual covenant.

In substance and in form, ‘owners' of these units are a lessee of a lease of land and buildings. According to IFRS, the land and buildings elements of these leases should be considered separately for the purposes of lease classification under IAS 17.

Allocation of the interests in leases of land and building

IAS 17
When a lease includes both land and buildings elements, we should assess the classification of each element as a finance or an operating lease separately. (Except, if the amount that would initially be recognised for the land element is immaterial, the land and buildings ma y be treated as a single unit for the purpose of lease classification. In such a case, the economic life of the buildings is regarded as the economic life of the entire leased asset.)

In determining whether the land element is an operating or a finance lease, an important consideration is that land normally has an indefinite economic life, which makes most of the land elements operating leases.

However, this is not always the case. Land elements can be classified as a finance lease if significant risks and re wards associated with the land during the lease period would have been transferred from the lessor to the lessee despite there being no transfer of title. For example, consider a 999-year lease of land and buildings. In this situation, significant risks and rewards associated with the land during the lease term would have been transferred to the lessee despite there being no transfer of title.

Separate measurement of the land and buildings elements is not required when the lessee’s interest in both land and buildings is classified as an investment property in accordance with IAS 40 and the fair value model is adopted.

Classification as property, plant and equipment or as an investment property

The issue is complicated when the separate elements of the land and buildings are further classified in accordance with IAS 16, Property, Plant and Equipment and IAS 40, Investment Properties.

IAS 16
According to IAS 16, land and buildings are separable assets and are accounted for separately, even when they are acquired together. Land has an unlimited useful life and, therefore, is not depreciated. Buildings have a limited useful life and, therefore, are depreciable assets. An increase in the value of the land on which a building stands does not affect the determination of the depreciable amount of the building.

IAS 40
A property interest that is held by a lessee under an operating lease may be classified and accounted for as investment property provided that:

• the rest of the definition of investment property is met
• the operating lease is accounted for as if it were a finance lease in accordance with IAS 17, Leases, and
• the lessee uses the fair value model for investment property
  

The choice between the cost and fair value models is not available to a lessee accounting for a property interest held under an operating lease that it has elected to classify and account for as investment property. The standard requires such investment property to be measured using the fair value model.

IAS 40 depends on IAS 17 for requirements for the classification of leases, the accounting for finance and operating leases and for some of the disclosures relevant to leased investment properties. When a property interest held under an operating lease is classified and accounted for as an investment property, IAS 40 overrides IAS 17 by requiring that the lease is accounted for as if it were a finance lease.

Scenario summaries

Scenario 1: Long-term lease of land

Element	Option 1	Option 2	Option 3	Option 4
Land	IAS 16 (Cost model)	IAS 16 (Revaluation model)	IAS 40 (Cost model)	IAS 40 (Fair model)
Buildings	IAS 16 (Cost model)	IAS 16 (Revaluation model)	IAS 40 (Cost model)	IAS 40 (Fair model)

Land element is classified as a finance lease under IAS 17 as significant risks and rewards associated with the land during the lease period would have been transferred to the lease despite there being no transfer of title.
The land should be recognised under IAS 16 (option 1 and 2) if it is owner-occupied or under IAS 40 (option 3 and 4) if it is used for rental earned.

• Option 1: Both land and buildings elements are measured at cost and presented under Property, Plant and Equipment in the statement of financial position. No depreciation is required for the land element but it is required for the buildings element.
• Option 2: Both land and buildings elements are measured at fair value with changes being posted to equity and presented under Property, Plant and Equipment in the statement of financial position. No depreciation is required for the land element but it is required for the buildings element.
• Option 3: Both land and buildings elements are measured at cost and presented under investment property in the statement of financial position. No depreciation is required for the land element but is required for the buildings element.
• Option 4: Both land and buildings elements are measured at fair value and presented under investment property in the statement of financial position. No depreciation is required for either the land element or buildings element.

Scenario 2: Short-term lease of land

Element	Option 1	Option 2	Option 3	Option 4
Land	IAS 17	IAS 17	IAS 17	IAS 40 (Fair value model) – for both land and building
Buildings	IAS 16 (Cost model)	IAS 16 (Revaluation model)	IAS 40 (Cost model)

Land element is classified as an operating lease under IAS 17 because it has indefinite economic life.
The land element should be recognised under IAS 17, as prepaid lease payments that are amortised over the lease term. Except for, it can be classified as investment property and the fair value model is used (option 4).
The buildings element should be recognised under IAS 16 (option 1 and 2) if it is owner occupied or under IAS 40 (option 3 and 4) if it is used for rental earned.

• Option 1: Land element is measured as prepaid lease payments that are amortised over the lease term. While the buildings element is measured at cost and presented under Property, Plant and Equipment in the statement of financial position. Depreciation is required for the building element.
• Option 2: Land element is measured as prepaid lease payments that are amortised over the lease term. While the buildings element is measured at fair value with changes being posted to equity and presented under Property, Plant and Equipment in the statement of financial position. Depreciation is required for the building element.
• Option 3: Land element is measured as prepaid lease payments that are amortised over the lease term. While the buildings element is measured at cost and presented under Investment property in the statement of financial position. Depreciation is required for buildings element.
• Option 4: Both land and buildings elements are measured at fair value and presented under Investment property in the statement of financial position. No depreciation is required for the land element and buildings element.

Scenario 3: Land element is immaterial

Element	Option 1	Option 2	Option 3	Option 4
Land	All the purchase price will be treated as buildings element
Buildings	IAS 16 (Cost model)	IAS 16 (Revaluation model)	IAS 40 (Cost model)	IAS 40 (Fair model)

As the land element is immaterial, the land and buildings elements are treated as a single unit for the purpose of lease classification. The economic life of the buildings is regarded as the economic life of the entire leased property.

• Option 1: Property is measured at cost and presented under Property, Plant and Equipment in the statement of financial position. Depreciation is required.
• Option 2: Property is measured at fair value with change being posted to equity and presented under Property, Plant and Equipment in the statement of financial position. Depreciation is required.
• Option 3: Property is measured at cost and presented under Investment property in the statement of financial position. Depreciation is required.
• Option 4: Property is measured at fair value and presented under Investment property in the statement of financial position. No depreciation is required.

Impairment review under IAS 36 is required to all assets at the reporting date except for those where the fair value model is adopted.
Linda Ng, HKCA Learning Media

Interpreting financial data

This article was written following marking of the December 2007 exam papers, which revealed more guidance was required on this topic
The transition from Paper F2 to Paper F5 cannot be underestimated. When preparing for the Paper F5 exam, students need to carefully consider what the examiner is looking for. The purpose of this article is to point students in the right direction when studying the interpretation of financial data – which is a major topic in the Paper F5 syllabus.
This article has been written following marking of the December 2007 exam papers. Although there were many very good answers to Question 2 (‘Ties Only’), it was clear that more guidance is needed for some candidates. Students are advised to look at Question 2 while reading this article, as extracts from the question are used to illustrate points and explain the techniques needed.

ASSESSING FINANCIAL PERFORMANCE

In the December 2007 exam, candidates were asked to assess the financial performance of the business in its first two quarters, when sales had jumped 61% from Quarter 1 to Quarter 2. This calculation should present no problem ((Q2/Q1) - 1) expressed as a % increase). However, an ‘assessment’ requires a qualitative comment or two. A percentage alone will not gain a pass mark.
In most questions there will be some background information – you should use it. Ties Only operated in a competitive environment – as stated in the question – and so a 61% increase in one quarter sounds pretty good in a competitive situation, and to say so will earn a mark. It was also the first two quarters of the business year and so this level of growth is impressive – another mark. If you then go on to say that such high growth rates are often hard to maintain, you will gain another mark. Top-scoring students should be aiming to make these kinds of observations. Hypothesising as to why the growth is happening is also a source of marks. Revenue growth can be the result of extra volume or increasing prices. In the case of Ties Only, it is much more likely to be increased volume; the price will surely be constrained by competition, and from the information provided in Part (b), you can work out that prices are falling (although that calculation was not required). Suggesting that Ties Only has secured more customers, and hence increased volume of sales, scored a mark.
Candidates must be brave and commit themselves. You must express an opinion. It is not acceptable to suggest that management investigate. Although in the real world this may well happen, in the exam hall you have to demonstrate that you know where to look.

INTERPRETATION

The principle of interpretation can be applied to other areas of the syllabus. In Question 3 of the December 2007 exam, candidates were required to interpret sales performance. Again, it is recommended that you refer to Question 3. Broadly, in this question, the market was shrinking and the company was struggling a little as a result. It had reduced sales prices and fought off an 11% fall in the market, losing only 2% of its budgeted sales. This is a good performance, taking the falling market into consideration.
I would expect candidates to be able to interpret the variances and reach the above conclusions. So, if you are given the following information:

• sales price variance $105,600 adv
• sales volume variance $28,000 adv
• sales market size variance $140,000 adv
• sales market share variance $112,000 fav

You should be able to hypothesise as to what has happened, using the information given in the question and your understanding of the data. Adverse sales price variance must mean that sales prices have fallen. This could be the result of competitive pressure. Adverse sales volume variance means that the business hasn’t achieved its budget, which is likely to disappoint management. However, the favourable market share variance is encouraging. This shows that business has been won from the competition, and that the business has also performed well in the areas that it can control.
The adverse market size variance shows a difficult trading environment, which is probably outside the control of the business. Performance should be assessed by taking into account the environment in which a business operates and separating the controllable from the uncontrollable. Note the link between adverse market size and adverse sales price. In the shrinking market of paper diaries (the product in the question), it is likely that the sales prices will fall as sellers scramble to retain as much share as possible.

KEY LEARNING POINTS

In summary: a ratio alone is not enough use the background information given (such as financial data, variances, or narrative) hypothesise as to possible causes and be prepared to select the most likely be brave and express your opinion do not ‘opt out’ and suggest that management 
Written by a member of the Paper F5 examining team

Linear programming

Decision making is an important aspect of the Paper F5 syllabus, and questions on this topic will be common. The range of possible questions is considerable, but this article will focus on only one: linear programming
The ideas presented in this article are based on a simple example. Suppose a profit-seeking firm has two constraints: labour, limited to 16,000 hours, and materials, limited to 15,000kg. The firm manufactures and sells two products, X and Y. To make X, the firm uses 3kg of material and four hours of labour, whereas to make Y, the firm uses 5kg of material and four hours of labour. The contributions made by each product are $30 for X and $40 for Y. The cost of materials is normally $8 per kg, and the labour rate is $10 per hour.
The first step in any linear programming problem is to produce the equations for constraints and the contribution function, which should not be difficult at this level.
In our example, the materials constraint will be 3X + 5Y ≤ 15,000, and the labour constraint will be 4X + 4Y ≤ 16,000. You should not forget the non-negativity constraint, if needed, of X,Y ≥ 0.
The contribution function is 30X + 40Y = C
Figure 1: Optimal production plan

Plotting the resulting graph (Figure 1, the optimal production plan) will show that by pushing out the contribution function, the optimal solution will be at point B – the intersection of materials and labour constraints.
The optimal point is X = 2,500 and Y = 1,500, which generates $135,000 in contribution. Check this for yourself (see Working 1). The ability to solve simultaneous equations is assumed in this article.
The point of this calculation is to provide management with a target production plan in order to maximise contribution and therefore profit. However, things can change and, in particular, constraints can relax or tighten. Management needs to know the financial implications of such changes. For example, if new materials are offered, how much should be paid for them? And how much should be bought? These dynamics are important.
Suppose the shadow price of materials is $5 per kg (this is verifiable by calculation – see Working 2). The important point is, what does this mean? If management is offered more materials it should be prepared to pay no more than $5 per kg over the normal price. Paying less than $13 ($5 + $8) per kg to obtain more materials will make the firm better off financially. Paying more than $13 per kg would render it worse off in terms of contribution gained. Management needs to understand this.
There may, of course, be a good reason to buy ‘expensive’ extra materials (those costing more than $13 per kg). It might enable the business to satisfy the demands of an important customer who might, in turn, buy more products later. The firm might have to meet a contractual obligation, and so paying ‘too much’ for more materials might be justifiable if it will prevent a penalty on the contract. The cost of this is rarely included in shadow price calculations. Equally, it might be that ‘cheap’ material, priced at under $13 per kg, is not attractive. Quality is a factor, as is reliability of supply. Accountants should recognise that ‘price’ is not everything.
How many materials to buy?
Students need to realise that as you buy more materials, then that constraint relaxes and so its line on the graph moves outwards and away from the origin. Eventually, the materials line will be totally outside the labour line on the graph and the point at which this happens is the point at which the business will cease to find buying more materials attractive (point D on the graph). Labour would then become the only constraint.
We need to find out how many materials are needed at point D on the graph, the point at which 4,000 units of Y are produced. To make 4,000 units of Y we need 20,000kg of materials. Consequently, the maximum amount of extra material required is 5,000kg (20,000 – 15,000). Note: Although interpretation is important at this level, there will still be marks available for the basic calculations.

WORKINGS

Working 1:
The optimal point is at point B, which is at the intersection of:
3X + 5Y = 15,000 and
4X + 4Y = 16,000
Multiplying the first equation by four and the second by three we get:
12X + 20Y = 60,000
12X + 12Y = 48,000
The difference in the two equations is:
8Y = 12,000, or Y = 1,500
Substituting Y = 1,500 in any of the above equations will give us the X value:
3X + 5 (1,500) = 15,000
3X = 7,500
X = 2,500
The contribution gained is (2,500 x 30) + (1,500 x 40) = $135,000
Working 2: Shadow price of materials
To find this we relax the material constraint by 1kg and resolve as follows:
3X + 5Y = 15,001 and
4X + 4Y = 16,000
Again, multiplying by four for the first equation and by three for the second produces:
12X + 20Y = 60,004
12X + 12Y = 48,000
8Y = 12,004
Y = 1,500.5
Substituting Y = 1,500.5 in any of the above equations will give us X:
3X + 5 (1,500.5) = 15,001
3X = 7,498.5
X = 2,499.5
The new level of contribution is: (2,499.5 x 30) + (1,500.5 x 40) = $135,005
The increase in contribution from the original optimal is the shadow price:
135,005 – 135,000 = $5 per kg.
Written by a member of the F5 examining team

The risks of uncertainty

This article introduces the concepts of risk and uncertainty together with the use of probabilities in calculating both expected values and measures of dispersion
Clearly, risk permeates most aspects of corporate decision-making (and life in general), and few can predict with any precision what the future holds in store.
Risk can take myriad forms – ranging from the specific risks faced by individual companies (such as financial risk, or the risk of a strike among the workforce), through the current risks faced by particular industry sectors (such as banking, car manufacturing, or construction), to more general economic risks resulting from interest rate or currency fluctuations, and, ultimately, the looming risk of recession. Risk often has negative connotations, in terms of potential loss, but the potential for greater than expected returns also often exists.
Clearly, risk is almost always a major variable in real-world corporate decision-making, and managers ignore its vagaries at their peril. Similarly, trainee accountants require an ability to identify the presence of risk and incorporate appropriate adjustments into the problem-solving and decision-making scenarios encountered in the exam hall. While it is unlikely that the precise probabilities and perfect information, which feature in exam questions can be transferred to real-world scenarios, a knowledge of the relevance and applicability of such concepts is necessary.
In this first article, the concepts of risk and uncertainty will be introduced together with the use of probabilities in calculating both expected values and measures of dispersion. In addition, the attitude to risk of the decision-maker will be examined by considering various decision-making criteria, and the usefulness of decision trees will also be discussed. In the second article, more advanced aspects of risk assessment will be addressed, namely the value of additional information when making decisions, further probability concepts, the use of data tables, and the concept of value-at-risk.
The basic definition of risk is that the final outcome of a decision, such as an investment, may differ from that which was expected when the decision was taken. We tend to distinguish between risk and uncertainty in terms of the availability of probabilities. Risk is when the probabilities of the possible outcomes are known (such as when tossing a coin or throwing a dice); uncertainty is where the randomness of outcomes cannot be expressed in terms of specific probabilities. However, it has been suggested that in the real world, it is generally not possible to allocate probabilities to potential outcomes, and therefore the concept of risk is largely redundant. In the artificial scenarios of exam questions, potential outcomes and probabilities will generally be provided, therefore a knowledge of the basic concepts of probability and their use will be expected.

PROBABILITY 

The term ‘probability’ refers to the likelihood or chance that a certain event will occur, with potential values ranging from 0 (the event will not occur) to 1 (the event will definitely occur). For example, the probability of a tail occurring when tossing a coin is 0.5, and the probability when rolling a dice that it will show a four is 1/6 (0.166). The total of all the probabilities from all the possible outcomes must equal 1, ie some outcome must occur.
A real world example could be that of a company forecasting potential future sales from the introduction of a new product in year one (Table 1).
Table 1: Probability of new product sales

Sales	$500,000	$700,000	$1,000,000	$1,250,000	$1,500,000
Probability	0.1	0.2	0.	0.2	0.1

From Table 1, it is clear that the most likely outcome is that the new product generates sales of £1,000,000, as that value has the highest probability.

INDEPENDENT AND CONDITIONAL EVENTS

An independent event occurs when the outcome does not depend on the outcome of a previous event. For example, assuming that a dice is unbiased, then the probability of throwing a five on the second throw does not depend on the outcome of the first throw.
In contrast, with a conditional event, the outcomes of two or more events are related, ie the outcome of the second event depends on the outcome of the first event. For example, in Table 1, the company is forecasting sales for the first year of the new product. If, subsequently, the company attempted to predict the sales revenue for the second year, then it is likely that the predictions made will depend on the outcome for year one. If the outcome for year one was sales of $1,500,000, then the predictions for year two are likely to be more optimistic than if the sales in year one were $500,000.
The availability of information regarding the probabilities of potential outcomes allows the calculation of both an expected value for the outcome, and a measure of the variability (or dispersion) of the potential outcomes around the expected value (most typically standard deviation). This provides us with a measure of risk which can be used to assess the likely outcome.

EXPECTED VALUES AND DISPERSION

Using the information regarding the potential outcomes and their associated probabilities, the expected value of the outcome can be calculated simply by multiplying the value associated with each potential outcome by its probability. Referring back to Table 1, regarding the sales forecast, then the expected value of the sales for year one is given by:
Expected value
= ($500,000)(0.1) + ($700,000)(0.2)
+ ($1,000,000)(0.4) + ($1,250,000)(0.2)
+ ($1,500,000)(0.1)
= $50,000 + $140,000 + $400,000
+ $250,000 + $150,000
= $990,000
In this example, the expected value is very close to the most likely outcome, but this is not necessarily always the case. Moreover, it is likely that the expected value does not correspond to any of the individual potential outcomes. For example, the average score from throwing a dice is (1 + 2 + 3 + 4 + 5 + 6) / 6 or 3.5, and the average family (in the UK) supposedly has 2.4 children. A further point regarding the use of expected values is that the probabilities are based upon the event occurring repeatedly, whereas, in reality, most events only occur once.
In addition to the expected value, it is also informative to have an idea of the risk or dispersion of the potential actual outcomes around the expected value. The most common measure of dispersion is standard deviation (the square root of the variance), which can be illustrated by the example given in Table 2, concerning the potential returns from two investments.
Table 2: Potential returns from two investments

Investment A		Investment B
Returns	Probability of return	Returns	Probability of return
8%	0.25	5%	0.25
10%	0.5	10%	0.5
12%	0.25	15%	0.25

To estimate the standard deviation, we must first calculate the expected values of each investment:
Investment A
Expected value = (8%)(0.25) + (10%)(0.5) + (12%)
(0.25) = 10%
Investment B
Expected value = (5%)(0.25) + (10%)(0.5) + (15%)
(0.25) = 10%
The calculation of standard deviation proceeds by subtracting the expected value from each of the potential outcomes, then squaring the result and multiplying by the probability. The results are then totalled to yield the variance and, finally, the square root is taken to give the standard deviation, as shown in Table 3.
Table 3: Application of standard deviation to potential returns

Investment A
Returns	Expected return	Returns minus expected returns	Squared	Probability	Column 4 x Column 5
8%	10%	-2%	4%	0.25	1%
10%	10%	0%	0%	0.5	0%
12%	10%	2%	4%	0.25	1%
				Variance	2%
				Standard deviation	1.414%

Investment B
Returns	Expected return	Returns minus expected returns	Squared	Probability	Column 4 x Column 5
5%	10%	-5%	25%	0.25	6.25%
10%	10%	0%	0%	0.5	0%
15%	10%	5%	25%	0.25	6.25%
				Variance	12.5%
				Standard deviation	3.536%

In Table 3, although investments A and B have the same expected return, investment B is shown to be more risky by exhibiting a higher standard deviation. More commonly, the expected returns and standard deviations from investments and projects are both different, but they can still be compared by using the coefficient of variation, which combines the expected return and standard deviation into a single figure.

COEFFICIENT OF VARIATION AND STANDARD ERROR

he coefficient of variation is calculated simply by dividing the standard deviation by the expected return (or mean):
Coefficient of variation = standard deviation / expected return
For example, assume that investment X has an expected return of 20% and a standard deviation of 15%, whereas investment Y has an expected return of 25% and a standard deviation of 20%. The coefficients of variation for the two investments will be:
Investment X = 15% / 20% = 0.75
Investment Y = 20% / 25% = 0.80
The interpretation of these results would be that investment X is less risky, on the basis of its lower coefficient of variation. A final statistic relating to dispersion is the standard error, which is a measure often confused with standard deviation. Standard deviation is a measure of variability of a sample, used as an estimate of the variability of the population from which the sample was drawn. When we calculate the sample mean, we are usually interested not in the mean of this particular sample, but in the mean of the population from which the sample comes. The sample mean will vary from sample to sample and the way this variation occurs is described by the ‘sampling distribution’ of the mean. We can estimate how much a sample mean will vary from the standard deviation of the sampling distribution. This is called the standard error (SE) of the estimate of the mean.
The standard error of the sample mean depends on both the standard deviation and the sample size:
SE = SD/√(sample size)
The standard error decreases as the sample size increases, because the extent of chance variation is reduced. However, a fourfold increase in sample size is necessary to reduce the standard error by 50%, due to the square root of the sample size being used. By contrast, standard deviation tends not to change as the sample size increases.

DECISION-MAKING CRITERIA 

The decision outcome resulting from the same information may vary from manager to manager as a result of their individual attitude to risk. We generally distinguish between individuals who are risk averse (dislike risk) and individuals who are risk seeking (content with risk). Similarly, the appropriate decision-making criteria used to make decisions are often determined by the individual’s attitude to risk.
To illustrate this, we shall discuss and illustrate the following criteria:
1 Maximin
2 Maximax
3 Minimax regret
An ice cream seller, when deciding how much ice cream to order (a small, medium, or large order), takes into consideration the weather forecast (cold, warm, or hot). There are nine possible combinations of order size and weather, and the payoffs for each are shown in Table 4.
Table 4: Decision-making combinations

Order/weather	Cold	Warm	Hot
Small	$250	$200	$150
Medium	$200	$500	$300
Large	$100	$300	$750

The highest payoffs for each order size occur when the order size is most appropriate for the weather, ie small order/cold weather, medium order/warm weather, large order/hot weather. Otherwise, profits are lost from either unsold ice cream or lost potential sales. We shall consider the decisions the ice cream seller has to make using each of the decision criteria previously noted (note the absence of probabilities regarding the weather outcomes).
1 Maximin
This criteria is based upon a risk-averse (cautious) approach and bases the order decision upon maximising the minimum payoff. The ice cream seller will therefore decide upon a medium order, as the lowest payoff is £200, whereas the lowest payoffs for the small and large orders are £150 and $100 respectively.
2 Maximax
This criteria is based upon a risk-seeking (optimistic) approach and bases the order decision upon maximising the maximum payoff. The ice cream seller will therefore decide upon a large order, as the highest payoff is $750, whereas the highest payoffs for the small and medium orders are $250 and $500 respectively.
3 Minimax regret
This approach attempts to minimise the regret from making the wrong decision and is based upon first identifying the optimal decision for each of the weather outcomes. If the weather is cold, then the small order yields the highest payoff, and the regret from the medium and large orders is $50 and $150 respectively. The same calculations are then performed for warm and hot weather and a table of regrets constructed (Table 5).
Table 5: Table of regrets

Order/weather	Cold	Warm	Hot
Small	$0	$300	$600
Medium	$50	$0	$450
Large	$100	$200	$0

The decision is then made on the basis of the lowest regret, which in this case is the large order with the maximum regret of $200, as opposed to $600 and $450 for the small and medium orders.

DECISION TREES

The final topic to be discussed in this first article is the use of decision trees to represent a decision problem. Decision trees provide an effective method of decision-making because they:

• clearly lay out the problem so that all options can be challenged
• allow us to fully analyse the possible consequences of a decision
• provide a framework in which to quantify the values of outcomes and the probabilities of achieving them
• help us to make the best decisions on the basis of existing information and best guesses.

A comprehensive example of a decision tree is shown in Figures 1 to 4, where a company is trying to decide whether to introduce a new product or consolidate existing products. If the company decides on a new product, then it can be developed thoroughly or rapidly. Similarly, if the consolidation decision is made then the existing products can be strengthened or reaped. In a decision tree, each decision (new product or consolidate) is represented by a square box, and each outcome (good, moderate, poor market response) by circular boxes.
The first step is to simply represent the decision to be made and the potential outcomes, without any indication of probabilities or potential payoffs, as shown in Figure 1.
The next stage is to estimate the payoffs associated with each market response and then to allocate probabilities. The payoffs and probabilities can then be added to the decision tree, as shown in Figure 2. The expected values along each branch of the decision tree are calculated by starting at the right hand side and working back towards the left recording the relevant value at each node of the tree.
These expected values are calculated using the probabilities and payoffs. For example, at the first node, when a new product is thoroughly developed, the expected payoff is:
Expected payoff = (0.4)($1,000,000) + (0.4)
($50,000) + (0.2)($2,000) = $420,400
The calculations are then completed at the other nodes, as shown in Figure 3. We have now completed the relevant calculations at the uncertain outcome modes.
We now need to include the relevant costs at each of the decision nodes for the two new product development decisions and the two consolidation decisions, as shown in Figure 4.
The payoff we previously calculated for ‘new product, thorough development’ was $420,400, and we have now estimated the future cost of this approach to be $150,000. This gives a net payoff of $270,400.
The net benefit of ‘new product, rapid development’ is $31,400. On this branch, we therefore choose the most valuable option, ‘new product, thorough development’, and allocate this value to the decision node.
The outcomes from the consolidation decision are $99,800 from strengthening the products, at a cost of $30,000, and $12,800 from reaping the products without any additional expenditure.
By applying this technique, we can see that the best option is to develop a new product. It is worth much more to us to take our time and get the product right, than to rush the product to market. And it’s better just to improve our existing products than to botch a new product, even though it costs us less.

Written by a member of the F5 examining team

INTEGRITY

Dear Colleague,

Last month we had training on Integrity as the bed rock of banking. For today, I still want talk more on Integrity as it relate to leadership.

Integrity is particularly important because those with integrity earn the respect and trust of others and they are more effective as leader. According to Jack Welch, people with integrity tells the truth and they keep their words, takes responsibility for their past actions, admit mistakes and fix them, they know the laws of the country, industries and companies both in letter and in spirit and abide by them, they play to win the right way by the rules. There is a common thing among experts who has study or written about modern leadership, that all leaders must act with integrity at all times, the reason for this is that subordinates are constantly observing the leader.

What is then the Integrity? Webster dictionary tell us that is the quality of bringing sound moral principles, uprightness, honesty & sincerity. However, a definition I found very interesting is the one attributed to bobby Johns who says integrity is what you do when no one is watching and that you do in private is who you are.

Integrity also involves the three R’s

·         Respect for yourself
·         Respect for others and;
·         Responsibilities for all your actions.

Therefore, integrity is the mirror revealing the truth about an individual or corporation. Integrity involves working the talk and not just talking it. On a personal level, Integrity involves both the part of who you are and what you do.

Integrity is measure by what individual does and does not do when no one is looking:

·         Did they own to their value and ethics?

·         Do they compromise what they believe it’s right?

·         Why at corporate level, we may want to ask, do corporate reports, filling and stakeholder communications state one thing when in reality the corporation is doing something else?

These questions are pertinent to our understanding of integrity and how it can shape the organization we work for.

According to Jack Welch, without integrity we have no organization, you have nothing, integrity is the foundation upon which you build something. Therefore to succeed in our chosen career and move the organization forward, we must do away with the do as I say not as you do attitude. We must imbibe such values that are based on moral principle of honesty, uprightness & sincerity.

Distinguish colleague, let end this by reminding us that you can preach a better sermon with your life than with your lips.

FOOD FOR THOUGHT

“Integrity without knowledge is weak and useless and knowledge without integrity is dangerous and gravely “(Samuel Johnson).

Thank you and God bless.

 

Value chains, value networks and supply chain management

This article considers writer Michael Porter’s value chain framework, which has been described as a powerful analysis tool for companies in strategic planning to create value. It also highlights the various definitions of supply chain management put forward by different writers
Sections A4, E2 and E3 of the Syllabus and Study Guide relate to value chains and value networks, and Sections E2 and E3 of the Paper P3 Syllabus and Study Guide relate to the supply chain with particular, but not exclusive, reference to the application of e-business.
Value chains and supply chains have featured explicitly in the pilot paper, December 2007, December 2009 and June 2012 exams. In addition, value chains can often be used in position analysis.

The value chain and value networks

Porter’s value chain displays groupings of all the activities that organisations carry out. The activities are divided into primary activities and secondary activities. All activities have costs and successful businesses organise and carry out their activities in such a way that value is added. It is the value added that allows revenues to exceed costs so that profits are made.

To add value, the organisation must be doing more for its customers than simply carrying out the ‘face value’ of the activities, otherwise customers would presumably carry out the activities themselves. Customers either cannot carry out the activities at all, or cannot match costs, or don’t want to carry on the activities and so are willing to pay others to carry them out instead. For example:

• knowhow – suppliers often use knowhow that customers simply don’t have

• economies of scale – suppliers often produce efficiently in huge volumes with each customer buying only a small proportion. Suppliers’ economies of scale simply cannot be replicated by each customer

• risk – suppliers might shoulder production risks that customers don’t want

• location – suppliers might be in a low-cost area while customers are in a high cost area

• flexibility – suppliers are variable costs, while doing it yourself usually entails more fixed costs.

As always, success in business arises from one of Porter’s generic strategies – cost leadership or differentiation – each with or without focus. Value chains have to underpin the chosen generic strategy. So, if cost leadership is the strategy, the value chain adds value by enabling low cost production.
Curiously, the value chain relegates procurement (the purchase of goods and non-current assets) to a support activity, yet has sales and marketing in primary activities. In modern manufacturing companies this disparity does not make a lot of sense because what is important is the complete chain from suppliers to customers. This is acknowledged in the idea of value networks:

Value networks recognise that few companies stand alone and that what is ultimately supplied to and paid for by customers depends on activities carried on by many suppliers, distributors and, indeed, logistical companies. Ultimately, customer satisfaction and value added depend on all parties working well together.

The supply chain and supply chain management

There is no generally accepted definition of the term ‘supply chain management’ and many different definitions can be found in relevant literature. For example:
‘A concept whose primary objective is to integrate and manage the sourcing, flow and control of materials using a total systems perspective across multiple functions and multiple tiers of suppliers.’ La Londe and Masters (1994)
‘The objective of managing the supply chain is to synchronise the requirements of the customer with the flow of materials from suppliers in order to effect a balance between what are often seen as conflicting goals of high customer service, low inventory management, and low unit cost.’ Stevens (1989)
‘…an integrative philosophy to manage the flow of a distribution channel from supplier to the ultimate user.’ Cooper et al (1997)
From these definitions, it can be seen that supply chain management has the following features:

• Integrating and managing the sourcing, flow and control of materials.

• Supply chain management covers the flow of materials suppliers through to customers

• Potentially many suppliers and customers.

• Synchronising of materials received, processed and despatched to customers.

• Simultaneously achieving good levels of customer service and low costs for the company.

Supply chains are often divided into upstream and downstream operations in an analogy with material floating down a river, into and then out of operations:

• Upstream – the flow of materials into the organisation.

• Downstream – the flow of materials from the organisation to the customers.

However, these terms might sometimes have to be interpreted liberally as materials can go directly from supplier to customer with the organisation itself acting as a co-ordinator of the flow.
For businesses that manufacture their own products, the upstream supply chain will be taken to consist of the following value chain activities:

• Procurement – purchasing inputs such as supplies, material and equipment.

• Inbound logistics – receiving raw materials, holding inventory and issuing to manufacturing operations as required.

Downstream supply chain will be assumed to consist of:

• outbound logistics – the storing and distribution of finished goods.
• marketing and sales – identifying customer needs and generating sales.
• services.

You will note that procurement and marketing and sales do not
themselves involve any movement of goods, but these activities initiate the flows of raw materials, components and finished products, so need to be included as part of supply chain management. Service can also be included here as certainly the supply of elements such as consumables, maintenance and training can be valuable sources of value added and need to be managed.
A useful view of supply chain management is suggested by Meyr, Wagner and Rohde (2004):

Here, in contrast to Porter:

• procurement is seen as a primary activity and will include inbound logistics, or their equivalent. Procurement is a central part of the supply chain and not merely a support function. Wise and skilled purchasing, as well as the physical movement of goods, will be capable of creating value

• customer-facing activities (previously, sales, marketing and services) are combined into sales

• ‘production’ is used instead of ‘operations’ in Porter’s value chain. This is more precise (but perhaps more restricted).

The important additional emphasis in this presentation is on collaboration between up-stream suppliers and the down-stream customers. Together, they form the value network that creates value through the appropriate operation of the whole chain to improve efficiency, delivery accuracy and times, cost reduction and inventory minimisation.
You will readily understand that collaboration can often be greatly facilitated by the use of information technology, which can integrate online orders received from customers with manufacturing inventory management and purchases of raw materials and components from suppliers.

Push/pull supply chain models

A push model of the supply chain relies on manufacturers producing according to historical demand patterns and pushing products out to distributors and customers. Inventory is held at various points as a buffer against unexpected demand or production delays. By contrast, in a pull model demand stimulates production and delivery. Essentially, just-in-time inventory control is a pull model as ordering and production are triggered by customers’ orders. No orders are raised nor production started until there is downstream demand.
Of course, pure push or pull models exist only in theory: demand for a product will never cause a supply chain to start mining iron ore and producing steel. Nor will a push model guarantee that products made will be bought. At some point, in every supply chain, demand push will meet demand pull, and inventory will accumulate there. Note that large geographical distances between suppliers and customers, or processes that take time (such as growing crops) make pull systems more difficult to organise.
However, inventory can be minimised and customer service improved if all parties in the supply chain can be better synchronised and have the ability to react quickly. For example, a traditional model of replenishing inventory in supermarkets would rely on each supermarket issuing an order to suppliers, probably by electronic data interchange (EDI), once inventory falls below reorder level. However, orders then arrive ‘out-of-the-blue’ at suppliers, who either have to have sufficient production capacity or who have to hold inventories to respond quickly. A better way is to give suppliers access to supermarkets’ inventory records through an extranet so that inventory levels and rates of change can be monitored. Supplies can be dispatched even without having to wait for an order. In this way, suppliers will be much better able to anticipate demand and produce accordingly. Better synchronisation and lower inventory levels have been achieved.
Information technology is of great assistance in moving towards a pull model as it influences the downstream supply chain through the 6I’s of e-business:

• Intelligence – for example, internet sites can track user activity and from that analyse which products are growing or falling in popularity. Information can be fed directly into a data warehouse for subsequent analysis and data mining.

• Interactivity – internet customers can customise their purchases. For example, some computer companies build to order allowing different combinations of hardware and software to be chosen.

• Integration – following on from interactivity, once an order has been placed, the pull process can begin by scheduling component ordering, production and despatch.

• Individualisation – for example, relevant offers can be made to each customer. If someone has bought a particular printer, then subsequently offers can be made to sell ink or toner cartridges.

• Independence (from location) – the location of the supplier is largely irrelevant provided a good procurement and distribution system is in place. This is covered further below under logistics.

• Industry (structure) – fast responses to customer demand is liable to affect industry structure as it will often favour larger, better-organised companies who make use of sophisticated ordering and delivery solutions. There are fewer and fewer places in which poor performers can hide.

Supply chain choices

Supply chain pathways can be complex:

As with many other functions, outsourcing is increasingly used in supply chain management. Logistics companies can perform many supply chain functions more efficiently and economically than they can be done in-house, and we will see some examples below.
Some of the main choices to be made in supply chain pathways are as follows.
(1) Who transports the goods? The main solutions are:

• the buyer transfers them using own transport
• the seller transfers them using own transport
• a logistics company transfers them

(2) What delivery pathways are best?
(3) Who stores the goods? The organisation, the supplier, or a logistics company.
(4) Which manufacturing, packaging, labelling, kitting, or completion tasks are carried out by the organisation and which by other parties? (Kitting relates to processes such as adding batteries).
(5) Who is responsible for quality assurance and proper handling of the goods?
(6) How should returns be handled?
(7) How can fast and responsive deliveries by arranged?
(8) Who handles customs clearance?

Supply chain examples

Pharmaceutical: Many pharmaceuticals, such as insulin and flu vaccines, are temperature-sensitive and have to be stored below, say, 5°C to maintain their efficacy and safety. Manufacturers therefore need ensure that their worldwide distribution, by air and road, to hospitals and pharmacies can be guaranteed to have complied with the storage required and that this can be verified and demonstrated. It is not realistic for pharmaceutical companies to carry out such specialised distribution themselves on a worldwide basis, as this would imply refrigerated warehouses, air freight and transportation in every country supplied. Many logistics companies offer suitable services.
Packaging: Transporting packaging is wasteful, adding both weight and volume to products. Therefore, an efficient distribution solution can be to export the basic products and then package those locally with using language-specific packaging. Once again, it can be inefficient for manufacturers to do this and frequently logistics companies carry out locally the packaging, printing instructions and labelling.
Customs clearance: Each country tends to have its own import regulations and tariffs. Navigating through these requires considerable local expertise and logistics companies are often used to facilitate the efficient international movement of goods.
Distribution: Imagine you distribute a product throughout Europe and customers need stock replenished frequently and quickly. One solution would be to set up your own warehouses and distribution vehicles in every country. However, you will realise that this would require vast resources. Almost certainly it would be better to outsource this to a logistics company as that is likely to enjoy great economies of scale. The logistics company can both warehouse the goods locally and provide transport to customers allowing a more just-in-time approach to be taken.
Ken Garrett is a freelance lecturer and author